Gateway: At Profitability's Door?

March 01, 2005

By Sarah Lacy This is the "show me" year for long-troubled PC maker Gateway (GTW). Having dramatically restructured it in 2004 -- closing money-losing stores, backing away from consumer electronics, and cutting the workforce to a fourth of its size -- Gateway CEO Wayne Inouye needs to prove that the cow-themed PC maker can earn money again. If not, it's destined to be a PC also-ran.

So far, the numbers provide a mixed message. The fourth quarter of 2004 was good. Thanks to a merger with PC maker eMachines on Mar. 11 and an increased retail presence, Gateway's computer sales rose to 1.2 million units, up 128% from a year earlier and the highest number in 15 quarters, according to a Jan. 27 call with analysts.

NEW SELLING RELATIONSHIPS. Earnings amounted to $94 million, compared with a loss of $144 million a year earlier, but much of that gain resulted from Gateway retiring $100 million in stock held by AOL (TWX) -- not product revenues. Without it, the outfit would have lost $6.6 million.

But believe it or not, a bullish case can be made for the cow brand. Research firm First Global issued a report Mar. 1 that upgraded Gateway to a buy, noting that the "heavy lifting" of Inouye's restructuring was done, and nascent signs of cost-cutting's positive effects are emerging.

For one, Gateway has increased its market share. Earlier in the year, it was just over 5%, but in the fourth quarter it rose to 6.4% for U.S. PCs. That may be due to the drastic changes in how people buy the company's computers. With new store relationships, Gateway is working with a hybrid of Hewlett-Packard's (HPQ) retail PC strategy and Dell's (DELL) superefficient business. Gateway's marketing, sales, and administration costs are down from 23% to 9% -- about on a par with Dell. And execs believe they can trim a little more this year.

LITTLE RECOGNITION. Before investors get too enthusiastic, however, they should remember that Gateway still has to get through the first quarter of 2005. It said on Jan. 27 that it expects to break even or post a small loss on revenue of $810 million to $850 million. Analysts had been projecting a slight profit on revenues of $897 million. The stock fell on the news and hasn't recovered yet. It ended trading Mar. 1 at $4.63, down 1.5%.

Still, analysts say a first-quarter drop is to be expected from the new Gateway. With so much more of its sales coming from consumers shopping at big retailers, it's much more sensitive to holiday seasonality. If the second half looks bad, then they'll worry.

In truth, Gateway has been little rewarded for all of Inouye's accomplishments during his short tenure. Its stock is actually down slightly over the last year, despite the efficiencies introduced into the business. Head count has dropped from 8,500 to fewer than 2,000, and Gateway computers are in nearly every major North American electronics chain. While profits have been lacking, cuts from operations have been swifter than analysts expected, making good on Inouye's reputation as a lean and efficient manager. Many are hopeful the efficiencies will keep coming, and profitability won't be far behind.

SMALL RISK VS. BIG REWARD? In the meantime, other factors could goose Gateway's revenues this year. PC sales should increase, albeit by just 3% or so. But Gateway could get additional upside from more retail deals -- particularly in Europe where eMachines already has a presence. The company believes the demand exists. "There's not a week that goes by where I don't get a request to bring the Gateway value proposition to other parts of the world," Ed Fisher, the PC maker's senior vice-president for product planning, told BusinessWeek Online in November.

And the outfit is unveiling a series of new products this year, with a big thrust in notebooks. It debuted three new models on Jan. 31 and has more planned for midyear. The notebooks are about a quarter-inch thinner and sleeker than earlier models, with more battery power. Gateway is also going for a more sophisticated, hip look: Its logo is less cartoonish, just etched in chrome on the laptops' silver finish.

According to First Global, the stock can only go up from here. "Gateway is not going to trade much lower than its current stock price," First Global analysts Devina Mehra and Shobhit Khare wrote. "The risk is losing 15%. The reward can be to make 50%."

Most investors may not be ready for that much enthusiasm. After all, the PC industry is growing slowly, and grabbing market share from Dell and HP will be tough. But with the stock still not reflecting most of Inouye's improvements, chances are good that its potential is to the upside. Lacy is a reporter for BusinessWeek Online in the Silicon Valley bureau